Module: 1 (contd) Risks in Banking

The bulk of the resources of a commercial bank are by way of deposits by their customers. A commercial bank enjoys customers’ trust and confidence. Customers feel assured that the funds entrusted with the banks are safe and secure. But this customer-confidence is a sensitive factor. In case of adverse reports about the bank in the market, customers hasten to withdraw their deposits, and the resulting rush of withdrawals further aggravates the position. The crisis faced by one bank, may well spread to several other institutions to create a banking crisis in the country, further leading to severe economic repercussions. Government in several countries in such a situation rushes to the aid of the distressed bank, to recapitalise the crisis-affected institution to sustain its revival. It may be pointed out, in this context, that Government of India had not paid more than Rs.1000 Crore by way of compensation to share holders while nationalizing the commercial banks (first 14 and later 7). But the Government in the last one-decade had to incur an amount of around Rs.25000 Crore towards rehabilitation package of the weak nationalised banks. This brings to forefront the importance of alarming magnitude of a banking crisis to the national economy and the need for adequate risk management measures in the banking industry to ensure that the failure rate all times is pegged to zero level.

Traditionally banking as a system is provided with inbuilt safeguards against threats to its stability. The banks through age-old wisdom are adhering to three cardinal principles, viz. security, liquidity and profitability. The objectives of profitability (looking for reward) are counterbalance by rigid observance of the risk averting standards of "security" and "liquidity". Banks firmly follow and implement the basic doctrine of "spread" as a business policy and practice providing for widespread diversification in the timing and placement of their assets to provide for quick retrieval of a substantial part of their funds at any time. There are spreads in relation to the maturity schedules of assets, the geographical coverage and sector wiser coverage. A banker will shudder to keep all his eggs in a single basket.

Despite all this risks in banking manifest themselves in many ways as a result of many diverse activities, executed by these institutions from many locations and by numerous people. As a financial intermediary, banks borrow funds and lend them as a part of their primary activity. This intermediation activity, of banks exposes them to a host of risks. The volatility in the operating environment of banks will aggravate the effect of the various risks.

Based on the origin and their nature, risks are classified into various categories. The most prominent financial risks to which the banks are exposed to are:

1. Interest rate risk -Risk that arises when the interest income/ market value of the bank is sensitive to the interest rate fluctuations.

2. Foreign Exchange/Currency Risk- Risk that arises due to unanticipated changes in exchange rates and becomes relevant due to the presence of multi-currency assets and/or liabilities in the bank's balance sheet.

3. Liquidity risk - Risk that arises due to the mismatch in the maturity patterns of the assets and liabilities. This mismatch may lead to a situation where the bank is not in a position to impart the required liquidity into its system - surplus/ deficit cash situation. In the case of surplus situation this risk arises due to the interest cost on the idle funds. Thus idle funds deployed at low rates contribute to negative returns.

4. Credit Risk - Risk that arises due to the possibility of a default/delay in the repayment obligation by the borrowers of funds.

5. Contingency risk- Risk that arises due to the presence of off-balance sheet items such as guarantees, letters of credit, underwriting commitments etc

The intermediation activity of the banks exposes them to various risks not by chance but by choice. The price at which the banks mobilize and transfer funds depends essentially on two parameters - the time for which the funds are made available and the credit worthiness of the person to whom the funds are made available. Considering that the long-term transfer of funds and short-term funds and a high-risk borrower are priced at different interest rates, banks will have to take liquidity risk and/or credit risk to earn the spreads. There is also a definite linkage between the various risks faced by banks, as being brought out subsequently in this report.

All banks face interest rate risk (IRR) and recent indications suggest it is increasing at least modestly. Although IRR sounds arcane for the layperson, the overheads incurred after the savings and loan crisis of the 1980s, when a few banks borrowed at a very heavy rate on daily basis in the inter-bank call money market averaging above 20% merely to confirm to SLR obligations, suggests there is good reason to learn at least a little about IRR.

Towards more effective management of diverse risks faced by commercial banks RBI has recently introduced Risk-based Supervision as a system of random and more frequent inspections based on the risk profile of individual banks, replacing the regular annual inspection.

The risk based supervision approach entails the monitoring of banks by allocating supervisory resources and focusing supervisory attention according to the risk profile of each institution. The instruments of risk-based supervision will be by way of enhancements of the supervisory tools traditionally used, viz., off-site monitoring and on-site examination supplemented by a market intelligence mechanism. In this regard, the Reserve Bank would be engaging services of reputed international consultants to draw on other countries' experiences and to develop an overall plan for moving towards RBS, which would incorporate international best supervisory practices suited for Indian conditions." (Mr.Bimal Jalan, former Governor of RBI)

The introduction of RBS would require the banks to reorient their organisational set up towards RBS and put in place an efficient risk management architecture, adopt risk focused internal audit, strengthen the management information system, and set up compliance units. The banks would also be required to address HRD issues like manpower planning, selection and deployment of staff and their training in risk management and risk based audit. It is evident that change management is a key element in RBS and the banks should have clearly defined standards of corporate governance, well-documented policies and efficient practices in place so as to clearly demarcate the lines of responsibility and accountability so that they align themselves to meet the requirements of RBS.

Under risk-based internal audit, the focus will shift from the present system of full-scale transaction testing to risk identification, prioritization of audit areas and allocation of audit resources in accordance with the risk assessment. Banks will, therefore, need to develop a well-defined policy, duly approved by the Board, for undertaking risk-based internal audit. The policy includes the risk assessment methodology for identifying the risk areas based on which the audit plan would be formulated. The policy also lays down the maximum time period beyond which even the low risk business activities/locations should not remain unaudited.

RBI has also provided banks with appropriate guidelines for managing diverse risks like credit risk, market risk and asset-liability (mismatch) risk. Managing these risks includes appropriate counter-effecting strategies.

Asset-liability risk is a leveraged form of market risk. Because the capital (surplus) of a financial firm such as a bank or insurance company is small relative to its assets or liabilities, small percentage changes in assets or liabilities can translate into large percentage changes in capital. Consider the evolution over time of a hypothetical company's assets and liabilities. Over the period, the assets and liabilities may change only slightly, but those slight changes dramatically alter the company's capital (which is just the difference between assets and liabilities). Consider a hypothetical bank with Rs.80 Crore in assets, Rs.60 Crore of it in liabilities and Rs.20 Crore in equity capital. A fall of Rs.10 Crore (representing a fall of 12.5%) in asset will reduce capital by Rs.10 Crore i.e. 50% fall.

The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted by narrowing of the difference between assets and liabilities—that the values of assets and liabilities might fail to move in tandem. Asset-liability risk is a leveraged form of risk. The capital of most financial institutions is small relative to the firm's assets or liabilities, so small percentage changes in assets or liabilities can translate into large percentage changes in capital.

Asset-liability risk is leveraged by the fact that the values of assets and liabilities each tend to be greater than the value of capital. In this example, modest fluctuations in values of assets and liabilities result in a 50% reduction in capital.

Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset-liability management (ALM) departments to assess asset-liability risk. They established ALM committees comprised of senior managers to address the risk.

Banks and Insurance Companies address this risk by structuring their assets to hedge their liabilities. For example, if a liability represents a long-dated fixed income obligation, a company might hold long bonds as a hedging asset. In this way, changes in the value of the liability are mirrored by changes in the value of the assets, and capital (the difference between the two) is unaffected.

Asset-liability management can be performed on a per-liability basis, matching a specific asset to support each liability. Alternatively, it can be performed across the balance sheet. With this approach, the net exposures of the organization’s liabilities are determined, and a portfolio of assets is maintained which hedges those exposures. For example, a life insurance company might determine the net duration and convexity of all its liabilities and then structure its assets to have the same duration and convexity.

Worldwide acceptance of Basel Accord standards on Capital Adequacy, classifying/grading assets according to the extent of risk exposure prescribing extent of capital in relation to risk-weighted assets is indeed a measure to protect against erosion of capital due to erosion in assets due to deficient quality of such assets